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Snakes and ladders

28 January 2016

Global matters continue to dictate whether the UK economy moves forward or back.

Britain may be an island, but in economic matters what happens here is powerfully influenced by what happens in the rest of the world. A prime concern about the global economy in 2015 was China, whose growth rate slowed, giving rise to fears of a hard landing. But some degree of slowdown was inevitable. When a country is very under-developed there is a big gap between its own position and that of the global leader. This affords ample scope to register rapid economic growth just by catching up with the leader. The closer the country is to the leader (i.e., the more developed it is), the less the scope for catch-up growth. We have already seen that in economies like Japan, Korea and Taiwan.

But there are some structural issues that could threaten something worse than a hard landing if they are allowed to get out of hand. In China, investment is running at just under 50% of GDP1. The authorities have got to put more emphasis on reducing investment and boosting consumption. Connected with the investment boom, there are serious issues with debt; both the sort that sits on bank balance sheets and the sort financed by bonds. Debt has risen very fast and some of it is of dubious quality. Accordingly, there is a risk of a financial crisis and this risk will be all the greater if the economy slows down markedly.

Even so, while I am sure that there will be bumps and dips, I am not unduly worried about China. There was a panic in the summer because the stock market fell, but that was confusing the economy with the markets. The Shanghai Composite did fall sharply but it had also risen sharply beforehand, so a fall was not a surprise and won’t have adverse consequences for the economy. Most importantly, the Chinese authorities have ample room to take stimulative action. And, if the need arises, they will.

Meanwhile, in Japan, the policies pursued by Prime Minister Shinzo Abe, known as Abenomics, are along the right lines. But the authorities have not been determined enough in the fight against deflation. To find its way out of the deflationary trap in which it seems to be, and to overcome its huge fiscal imbalances, Japan needs several years of quite high inflation – 4%, 5% or even 6% – combined with continued low interest rates. That means that the yen needs to be forced lower and quantitative easing needs to be expanded to a level not yet envisaged. Without that, we are likely to see more of the same.

By contrast, I am pretty confident about the US. There are occasional weaker months, but job creation is generally sound and the recovery is deep-seated. I do not see what could send it off course. A stronger dollar is a concern but the US is still much less involved in international trade than other countries.

The eurozone remains one of the main reasons for weakness in the global economy.

Admittedly, it has recently got a bit better: Ireland has been enjoying reasonable growth and Spain seems to be digging its way out of the mire. But overall growth is very weak. The problems remain acute in Greece and chronic in Italy; France remains unreformed and there is little prospect of that changing.

There is also growing uncertainty over Europe’s political future. Elections in France and Germany are on the horizon. Mass migration poses a major political challenge for Europe, while Angela Merkel’s suggestion of accelerated EU membership for Turkey has not been well received.

Across the Continent there is increasing euro-scepticism; and if Britain leaves the EU, that could further inflame sentiment.

The prospect of a break-up of the euro has, on the face of it, gone away but that is just superficial. This is a rolling crisis that comes and goes. Greece’s deal with its creditors was predicated on two conditions: passing and enacting economic reforms, and returning its budget deficit to acceptable levels. The key question is what will happen if and when Greece fails to meet these promises and needs more money. What will the lenders do?

This brings me to the UK. One of the key issues facing the economy here is fiscal tightening (ie, increases in taxes and reductions in public spending). The government eased off before the election but tightening is now resuming and that will be a restraining factor for the economy in the year ahead. Mind you, real wages, which were falling not that long ago, are rising again and that should continue to help the economy withstand the impact of the fiscal squeeze.

Employment growth should continue to be reasonably good and I expect unemployment to edge down, although not as much as previously. I am, however, worried by the increase in wage costs implied by the introduction of the National Living Wage, which I think will cause job losses in the hospitality and retail sectors. I think bosses will not allow wage increases at the bottom to reduce differentials between employees. So there will be a more general increase in wage costs, leading to job losses. Nevertheless, I am more than hopeful that the economy will be strong enough to withstand this.

I have long been a dove on interest rates. Just after the financial crisis, I predicted that interest rates would stay at their record low for five years. Most commentators thought that I was wrong, but more than six years on, we are still there. But not for long. I think there will be an increase in 2016, although no one can predict exactly when. I get the sense that policymakers are anxious to get on with the job of normalising rates, albeit gradually.

Inflation will obviously increase sharply in 2016 but this should not cause alarm. It has fallen to zero, and in some months just below, because of the drop in oil and other commodity prices. As this falls out of the annual comparison, we will see an increase in inflation towards the target rate. The Bank of England may then get anxious that this will increase inflation expectations and this will filter through to higher wages. But I am quite confident that inflation here will not be racing back to troubling levels for a good many years yet.

Economists are not – and should not try to be – market tipsters. What they can do is point to situations where asset classes look to be valued fairly – or not – in relation to the long-run economic fundamentals. Among investment classes, bonds currently look to me to be extremely expensive. I do not know when that will change, and they could be fine for the next year or so. But over the medium term, there is no doubt about the direction bonds will take: you don’t want to be holding the parcel when the music stops.

Large-cap UK equities, on the other hand, look better. Although their yields and outlook are not exactly exciting, they offer reasonable value. I would be surprised if they did not give a decent return over the medium to long term.

Has QE worked?

It is impossible to say how successful the policy of quantitative easing (QE), often referred to colloquially as ‘printing money’, has been in promoting economic recovery, as we do not know what would have happened without it. That said, I think that QE was vital in sustaining confidence when the crisis erupted. There were points in 2008/09 when it seemed that there was nothing policymakers could do. By using QE to pump in liquidity, the markets were reassured that some action was being taken. So, in that respect it might have saved us from a fate akin to the 1930s – or even worse.

But I do not think that QE has been massively significant recently. I do not even think it has had a particularly big impact on asset prices. There has been an impact on bonds to a certain extent; but most of the depression of bond yields, I think, has been the result of the extended policy of very low short-term interest rates, and of regulatory policy that has pushed funds towards holding bonds rather than equities.

Many people find the idea surprising that QE hasn’t had, and won’t have, a dramatic inflationary effect. But in an economy recovering from a financial crisis, the financial system does not work properly and so financial stimuli, including QE, do not work properly either. When the time is right, QE can be reversed.

1 http://data.worldbank.org, February 2015

 

The opinions expressed are those of Roger Bootle and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice. The views are not necessarily shared by other investment managers or by St. James's Place Wealth Management.

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